Morgan Stanley's contingent income autocallables linked to BofA likely to be short-term play

By Emma Trincal

New York, Aug. 12 - Morgan Stanley's contingent income autocallable securities due August 2016 linked to Bank of America Corp. shares may offer too little risk reward benefit to investors even if the structure, with its step-up redemption threshold, offers some appeal, sources said.

If Bank of America stock closes at or above the 80% barrier level on a quarterly review date, the notes will pay a contingent payment at an annual rate of 8.9% to 10.9% for that quarter. The exact contingent quarterly coupon will be set at pricing, according to an FWP filing with the Securities and Exchange Commission.

If the shares close at or above the redemption threshold level on any of the first 11 quarterly determination dates, the notes will be redeemed at par of $10 plus the contingent payment. The redemption threshold will be 105% of the initial share price for the first four review dates, stepping up to 110% of the initial share price for the next four review dates and to 115% of the initial share price for the final three dates.

If the notes are not called, the payout at maturity will be par plus the contingent payment unless the stock closes below the 80% trigger level, in which case the payout will be a number of Bank of America shares equal to $10 divided by the initial share price or, at the issuer's option, the cash equivalent.

Jack Ablin, chief investment officer at BMO Private Bank, said that the notes are an income play. But the structure carries risk because if the final barrier is breached, investors have the same risk exposure as a long position in the stock.

"I guess that makes sense if people are willing to risk principal in a quest for incremental yield," he said.

Short life

Investors in the notes should be willing to see their investment called on the first call date, as it is the most probable scenario, said Carl Kunhardt, wealth adviser at Quest Capital Management, adding that it was even more so with Bank of America as the underlying stock.

"You're unlikely to see any [coupon] beyond the first quarter. You have opened up yourself to the risk of the stock, and you can't make more than 10% a year, which is likely to be 2.5% for three months and then you get called," he said.

"The best outcome for investors is to avoid the early redemption and to collect the coupon as long as possible. The issuer by stepping up the call level from 100% to 115% increases the odds of this outcome.

"But it's a moot point because you'll get called right away. With a 'strong buy' recommendation, come November, you're out."

He was referring to the "strong buy" rating by Raymond James.

"I can find other ways to get 2.5%. For instance, I could take a high-yield position for three months," he said.

"In order to do well with this note, you would have to have the conviction that the stock will trade in a range. You could pull the company's fundamentals, the financials and you can convince yourself bullish or bearish. But to say, 'I'm going to be neither' is a different story."

Al Baker, financial adviser at Pathway Financial, said, "It all depends on your belief on the stock. If you thought the share price would stay flat or would go slightly up, then you probably could buy this. I guess you'd have to be mildly bearish or mildly bullish."

To be sure, strong bulls should stay away from the notes, Kunhardt said.

"This is another risk you're taking. Bank of America is an aggressive growth, strong buy. That means that my investment in the notes is going to be short-lived, three months, as I said before. If I have $10,000 to invest, do I put it in the stock or in the notes? Say the stock takes off. At the end of three months, I've made $250 with the notes. If the stock is up 15% on that quarter, I've lost $1,500. I would have done six times better with the stock," he said.

Bank of America stock has gained 10.75% over the past three months. It is up 24% for the year.

"If you feel that strongly about the stock, you should buy directly," Kunhardt added.

Unknown duration

Some investors may not be comfortable with the uncertain duration of the product. Investors should assume that they will be invested for three years even if they are likely to see their notes called away before maturity, said Baker.

"If you are moderately bullish and willing to be a long-term holder, you could enter in that kind of strategy," Baker said.

"But I think an investor would be better off in a covered call strategy. For instance, they may do better with DPD if only to have more liquidity."

He was referring to the Dow 30 Premium & Dividend Income Fund Inc., a closed-end fund that invests in the 30 stocks included in the Dow Jones industrial average while writing covered call options on some or all of the stocks for income. The fund trades on the NYSE Arca under the ticker symbol "DPD."

"With DPD, you'd getting the income and a reasonable chance of participating in the upside. You also can get out anytime, while liquidity is limited with this note," he said.

Overall, the risk reward of the product was not considered attractive by those advisers.

"This is a cousin of a reverse convertible," Kunhardt said.

"I never understood those structures because you have the cap on the upside, which is your potential income, and at the same time, you are being protected by a barrier that can easily be breached, giving you full downside exposure, with the possibility of losing your entire principal. If I'm going to take that risk, I'm going to roll the dice and just buy the stock. I can create a stop loss order at 20% below entry point and get the same protection."

Having exposure to a single stock creates an extra risk, said Baker.

"This trade is OK I guess if you're on the right side of the stock," he said.

"But if the banking stocks sell off, you're stuck.

"I wouldn't put my clients in that investment. I think the risk reward is mediocre."

Morgan Stanley & Co. LLC is the agent with Morgan Stanley Smith Barney LLC as dealer.

The notes will price and settle in August.

The Cusip number is 61762P567.

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